Fed’s Dudley Signals a Shift Toward Bank Reform

By Simon Johnson -
Nov 25, 2012

This is now the standard line from
Wall Street lobbyists: Don’t worry about “too big to fail”
financial institutions because the Dodd-Frank Act fixed the
problem.

The implication is that Congress should relax and not push
any additional changes, such as capping the size of our largest
banks in a meaningful way or forcing them to simplify their
legal structures. If regulators lack support on Capitol Hill,
they won’t try as hard.

On Nov. 15, resistance to this industry view came from a
surprising place: a speech by William Dudley, the president of
the Federal Reserve Bank of New York. That institution isn’t
usually associated with strong pro-reform positions, yet Dudley
was unexpectedly forceful on three points.

First, he made clear that too big to fail remains with us.
Some very large financial institutions receive implicit
government subsidies in the form of downside protection (or at
least the market’s perception that such protection exists). This
insurance is free of charge and allows them to borrow more
cheaply, and presumably encourages them to become even larger.
Now, whenever someone questions the existence of these dangerous
subsidies, I will cite Dudley’s speech.

Living Wills

Second, I was struck by Dudley’s admission that the
recently completed first round of living wills -- potential
liquidation plans drawn up by major financial institutions --has
been far from satisfactory. I encounter industry lawyers who
assert that living wills provide a clear road map for winding
down systemically important financial institutions. I will also
refer these people to Dudley’s speech, in which he confirms that
living wills have accomplished no such thing.

“We are a long way from the desired situation in which
large complex firms could be allowed to go bankrupt without
major disruptions to the financial system and large costs to
society,” Dudley said.

Still, the New York Fed president says that living wills
are an “iterative process” that will take some time to work.
My view is that they are a sham, meaningless boilerplate and box
checking.

Third, Dudley is also perceptive on the difficulty of
applying to global banks the “orderly liquidation authority”
of Dodd-Frank’s Title II. The general idea is simple: Allow the
Federal Deposit Insurance Corporation to manage the
“resolution” of large financial institutions in the same way
it has handled the failure of banks with insured deposits since
the 1930s.

The insurmountable obstacle -- as critics have pointed out
for at least three years -- is that there is no cross-border
framework or process for handling the failure of big financial
institutions. Different countries have different rules, and
powerful people in those countries -- U.K. bankers or French
civil servants -- like it that way.

Here’s the heart of the matter with regard to over-the-
counter derivatives, as stated by Dudley in the nuanced language
of a central banker.

“Certain Title II measures including the one-day stay
provision with respect to OTC derivatives and other qualified
financial contracts may not apply through the force of law
outside the United States, making orderly resolution
difficult.”

Clear Language

First, he says that banks “hold” capital. This is the
wrong verb to use because it encourages relatively uninformed
readers to think of capital as an asset, rather than what it
really is, a liability, or shareholder equity.

The words of an influential official such as Dudley matter
because they pervade popular commentary and can lead to great
linguistic and conceptual confusion, for example on Capitol
Hill. They also encourage the illusion that higher (equity)
capital requirements will somehow hurt the ability of banks to
provide credit; in fact, more equity makes any financial system
safer and more resilient over the cycle.

We should expect our central bankers to speak clearly and
explain issues in terms that people can understand. Dudley is
calling for more equity, relative to debt, in the financial
system. He should use plain English to make this essential
point.

Second, the logic of Dudley’s speech draws the reader to
the idea that megabanks should greatly simplify their legal
structures, which would make any kind of liquidation easier. At
the largest financial institutions, the relationship between
business units and legal entities has become hopelessly
complicated, creating a major difficulty in any insolvency or
resolution process. Disappointingly, while Dudley flags the
general issue, his language is opaque and he doesn’t press for
immediate action -- despite the industry having no good reason
for maintaining this degree of complexity.

Finally, Dudley calls on proponents of breaking up our
largest banks -- so they become small enough and simple enough
to fail -- to explain in more detail how this could be done and
what the precise implications would be.

There is great irony here. During the debate over the Dodd-
Frank Act in spring 2010, genuine reformers such as Senator Ted Kaufman of Delaware pressed the administration on the likely
inadequacy of their “living wills” and “orderly liquidation
authority” approach.

Did the New York Fed or any other officials think
creatively with Kaufman and his allies about complementary
approaches, including a binding cap on size and leverage? The
answer is no. Led by the Treasury Department, they slammed the
door on all alternatives.

As Kaufman said at the time in a speech on the Senate
floor, why is the burden of proof on those who want to return to
the proven statutory and regulatory approaches of the past?

The onus should be on those who, after a devastating
financial crisis, continue to tinker at the margins of the
failed regulatory framework.

(Simon Johnson, a professor at the MIT Sloan School of
Management as well as a senior fellow at the Peterson Institute
for International Economics, is co-author of “White House
Burning: The Founding Fathers, Our National Debt, and Why It
Matters to You.” The opinions expressed are his own.)